Action The psychology of choice Assumptions of Neoclassical - PowerPoint PPT Presentation

Action The psychology of choice

Assumptions of Neoclassical Economics (“ Homo Economicus ”)  Selfishness – an individual chooses on the basis of his/her own interests (no true, systematic altruism)  Stable, exogenous preferences – what the individual wants is well-defined, available to introspection, and stable over time  Formal rationality – an individual’s preferences, tastes, etc. are consistent with each other

Today: Selfishness – an individual chooses on the basis of his/her own interests (no true, systematic altruism)  Stable, exogenous preferences – what the individual wants is well-defined, available to introspection, and stable over time  Formal rationality – an individual’s preferences, tastes, etc. are consistent with each other

Rational Choice Theories for Individuals  Utility theory – one agent, choice depends only on states of nature

Example: A decision that depends on states of nature  Options: − Plan picnic outdoors − Plan picnic indoors  Possible states of nature − Rain − No rain  Choice depends on likelihood of rain, relative quality of picnic indoors/outdoors with and without rain

Rational Choice Theories for Individuals (Von Neumann and Morgenstern, 1944)  Utility theory – one agent, choice depends only on states of nature  Game theory – more than one agent, choice depends on what other agents may choose

Example: a decision that depends on what others may do  Options: − Go to the beach − Go to the cinema  Your friend may choose to: − Go to the beach − Go to the cinema  You cannot control or know what your friend will do  Both of you know each other’s preferences  Choice depends on what you think your friend will do, which depends on what s/he thinks you will do, and so on…

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C  Choices under uncertainty are determined by expected utility − Expected utility is a probability-weighted combination of the utilities of all n possible outcomes O i

A Concave Utility Curve

Example: Application of Utility Theory  Options: − Gamble (50% chance to win $100; else $0) − Sure Thing (100% chance to win $50)  Expected values are the same: − EV(Gamble) = (.5)($100) + (.5)($0) = $50 − EV(Sure Thing) = (1)($50) = $50  But their expected utilities may still differ − EU(Gamble) = .5U($100) + .5U($0) − EU(Sure Thing) = U($50)

Expected utility theory says that utilities are…  Not directly observable (internal to an individual)  Not comparable across individuals  Constrained by revealed preferences (i.e. choices between gambles)

Do people’s choices obey the theory of expected utility (i.e., formal rationality)?

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B

Utility versus Preference (Lichtenstein and Slovic, 1971; 1973)  Ps given two options: − P bet: 29/36 probability to win $2 − $ bet: 7/36 probability to win $9  Two conditions: − Choose one: Most prefer P bet − Value the bets: Most value $ bet higher  Shows utility (based on cash value) is not consistent with revealed preference

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B − Contradicted by preference reversal

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B − Contradicted by preference reversal  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C

Tests of Transitivity (A. Tversky, 1969)  Ps shown ratings of college applicants on three dimensions: Applicant Intelligence Stability Social A 69 84 75 B 72 78 65 C 75 72 55 D 78 66 45 E 81 60 35 • Ps chose A over B, B over C, C over D, D over E, but……E over A (difference in intelligence outweighed)

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B − Contradicted by preference reversal  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C − Contradicted by three-option intransitivities (and preference reversals)

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B − Contradicted by preference reversals  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C − Contradicted by three-option intransitivities (and preference reversals)  Choices under uncertainty are determined by expected utility − Expected utility is a probability-weighted combination of the utilities of all n possible outcomes O i

Testing Expected Utility (Tversky and Kahneman, 1981)  Choose between − A. Sure win of $30 − B. 80% chance to win $45

Testing Expected Utility (Tversky and Kahneman, 1981)  Choose between: − A. Sure win of $30 − B. 80% chance to win $45  Choose between: − C. 25% chance to win $30 − D. 20% chance to win $45

Testing Expected Utility (Tversky and Kahneman, 1981)  Choose between: − A. Sure win of $30 [78 percent] − B. 80% chance to win $45 [22 percent]  Choose between: − C. 25% chance to win $30 [42 percent] − D. 20% chance to win $45 [58 percent]

Testing Expected Utility (Tversky and Kahneman, 1981)  Choose between: − A. Sure win of $30 [78 percent] − B. 80% chance to win $45 [22 percent]  Choose between: − C. 25% chance to win $30 [42 percent] − D. 20% chance to win $45 [58 percent]  But this pattern is inconsistent with EUT: − EU(A)>EU(B) => u($30)>.8u($45) − EU(D)>EU(C) => .25u($30)<.2u($45) − Multiply both sides of bottom inequality by 4: contradicts top inequality

Testing Expected Utility (Tversky and Kahneman, 1981)  Choose between: − A. Sure win of $30 [78 percent] − B. 80% chance to win $45 [22 percent]  Choose between: − C. 25% chance to win $30 [42 percent] − D. 20% chance to win $45 [58 percent]  But this pattern is inconsistent with EUT: − EU(A)>EU(B) => u($30)>.8u($45) − EU(D)>EU(C) => .25u($30)<.2u($45) − Multiply both sides of bottom inequality by 4: contradicts top inequality  This is called a “certainty effect”: certain gains have extra psychological value

Expected Utility Theory – Crucial Features  Utility (“degree of liking”) is defined by (revealed) preferences − i.e. U(A) > U(B) iff A is preferred to (chosen over) B − Contradicted by preference reversals  Preferences are well ordered − i.e. transitive: If A ≻ B and B ≻ C, then A ≻ C − Contradicted by three-option intransitivities (and preference reversals)  Choices under uncertainty are determined by expected utility − Expected utility is a probability-weighted combination of the utilities of all n possible outcomes O i − Contradicted by certainty effect

So, people’s choices do not obey formal rationality. Are their preferences nonetheless stable?

Neoclassical Assumptions About Preferences  The chosen option in a decision problem should remain the same even if the surface description of the problem changes (descriptive invariance)

A Test of Descriptive Invariance (Tversky and Kahneman, 1981)  Consider a two-stage game. In the first stage, there is a 75% chance to end the game without winning anything, and a 25% chance to move into the second stage. If you reach the second stage, you have a choice between − Sure win of $30 − 80% chance to win $45  Your choice must be made before the game starts, i.e. before the outcome of the first stage is known

A Test of Descriptive Invariance (Tversky and Kahneman, 1981)  Consider a two-stage game. In the first stage, there is a 75% chance to end the game without winning anything, and a 25% chance to move into the second stage. If you reach the second stage, you have a choice between − Sure win of $30 [74 percent] − 80% chance to win $45 [26 percent]  Your choice must be made before the game starts, i.e. before the outcome of the first stage is known

A Test of Descriptive Invariance (continued)  But this gamble is formally identical to a problem we saw earlier, namely: − Choose between:  C. 25% chance to win $30 [42 percent]  D. 20% chance to win $45 [58 percent]